October 12, 2012

Here we are, kicking off the third-quarter earnings season, and there's concern that it won't be so good. I, however, do think it will be good, at least for most of the companies that we hold in our portfolio.

One important area that investors should be looking at is the mean estimate of the analysts. An investor can see these for the current quarter, the next quarter, the current year and the next year. These can be used in different ways, such as how close they should come to the current quarterly estimate of looking out to next year for a future stock value.

Two of the examples I’ve chosen will be reporting earnings per share soon. One, Costco (Nasdaq: COST), has reported already. When looking at the mean estimate, I like to see no more than a 10 percent delta from top to bottom — any more than that and I begin to question the likelihood of meeting the estimate, or perhaps even coming close.

Costco, which reported earnings last week, had a quarterly EPS estimate of $1.31 with a low estimate of $1.25 and a high estimate of $1.37, a delta of 9.6 percent. Costco reported an EPS of $1.39 — a 6.1 percent beat. Looking out to the year ending August 2013, the mean estimate is $4.45, with a delta from top to bottom of 10.1 percent. The $4.45 is a number I would feel comfortable using for a target sell price. After reporting better-than-expected earnings per share, the August 2013 EPS estimate did rise to $4.46.

Another example would include BRE Properties (NYSE: BRE), which will be reporting its earnings Oct. 30 — estimated to be 60 cents for the quarter ending September 2012. The high estimate here is 61 cents, and the low is 57 cents, only a 7 percent delta. Looking out to December 2013, the year-end EPS estimate is $2.55, with the low estimate being $2.46 and the high estimate at $2.65, a 7.7 percent delta.

A word of caution on both of these companies: I picked them for their low percentage change from the top to bottom estimates. Costco trades at a 22.6 forward PE based on August 2013 EPS estimates, and BRE Properties 18.4. They're both at lofty levels, so I would caution investors about paying for companies with high valuations.

I received an email from Gary about Xinyuan Real Estate Co. Ltd. (NYSE: XIN), a Chinese real estate development company. He notes it has a low PE and mainly does construction in smaller Chinese cities, and recently bought land in Beijing and Brooklyn. He wonders if this might be a great move, or something to worry about.

Well, Gary, I always worry about something, but that is what makes a better investor, because he will look deeper into the fundamentals. The company has a nice year-over-year sales growth of 62 percent and EPS growth of 116 percent, both impressive. I checked the income statement, and everything looked OK with no strange entries. The company has a nice return on equity of 23.5 percent, and debt to equity is 31.8 percent. I really liked the price to tangible book value of 0.28 compared to the industry average of 4.3.

However, I’ve heard many stories about problems in Chinese real estate and a potential real estate bubble. If the assets, which are properties in this case, are overvalued when they receive their haircut, price to tangible book will increase along with a fall in the equity, which will also send the debt to equity higher — not a good thing.

The forward PE is also low at 1.9, but there is only one analyst who follows the company. It is risky to base one's target price on one analyst. Is he trying to do a “pump and dump” scheme by inflating the earnings per share, or maybe trying to short the stock, and therefore will say bad things about the company? Never depend on one analyst.

So, Gary, yes you do have a lot to worry about with this company. If you really like it and think it is worth some more time, read the annual report and find the section on its real estate holdings. Try to do some analysis to see if the real estate is really worth what the company says it is, and if so, you could have a big winner on your hands in the future.

I always warn investors when dealing with Chinese companies that they have a different system than we do here in the United States, so it's OK to be skeptical.